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Market Update

Why We Expect the Fed to Cut Interest Rates in 2023

When will interest rates go down? Here are four key takeaways from our updated forecast.

Wondering what’s in store for interest rates?

Though the Federal Reserve has announced it’s hiking interest rates—again—and economic turbulence persists, our long-term optimism about gross domestic product and inflation remains largely unchanged.

A recession in the next 12 months is about a coin-flip probability, but it will be short-lived if it occurs. Once the Fed wins the war against inflation, it will shift to cutting interest rates in order to get the economy moving again.

When Will Interest Rates Go Down?

We expect the Fed will pivot to easing monetary policy in mid-2023 as inflation falls back to its 2% target and the need to shore up economic growth becomes a top concern. The full analysis is detailed in our 2022 U.S. Interest Rate & Inflation Forecast.

  1. Interest-rate forecast. We project a year-end 2023 federal-funds rate of 3%, compared with 4% for consensus. Further out, our 2026 and long-run projection for the fed-funds rate and 10-year Treasury yield are 1.75% and 2.75%, respectively. We do, however, expect interest rates to dip below these levels in 2024 and 2025 as monetary policy leans accommodative.
  2. Inflation forecast. We project price pressures to swing from inflationary to deflationary by 2023, owing greatly to the unwinding of price spikes caused by supply constraints in durables, energy, and other areas. This will make the Fed’s job of curtailing inflation much easier. In fact, we think the Fed will overshoot its goal with inflation averaging 1.7% over 2023-26.

A line chart showing Morningstar's current interest-rate forecasts.

The inflation analysis is critical to our near-term projections for GDP and interest rates. If inflation becomes much more entrenched, the Fed will have to engineer a sharp short-run recession by hiking interest rates much higher than we expect.

As long as the Fed is allowed to shift to easing in 2023, GDP should avoid a large downturn and start to accelerate in 2024 and 2025. Housing, which is the most interest-rate-sensitive major component of the GDP, will drive much of the fluctuation in GDP growth. Lower rates in 2024 and 2025 will be needed to improve housing affordability via lower mortgage rates and thereby resuscitate demand in an ailing housing market.

For investors, the Fed’s pivot should provide welcome relief. Rising interest rates have played a key role in the selloff in both stocks and bonds in 2022. Bonds will certainly rally if yields fall in line with our forecasts for the next five years. And while not guaranteed, we expect that falling interest rates would likely also lift stock prices.

We Expect a More Delayed Recovery, but a More Bullish Long-Run GDP

Since our last update, we’ve slightly lowered our near-term GDP forecasts. Altogether since the start of the year, our near-term GDP forecasts have come down substantially owing to supply shocks (especially the war in Ukraine) and a heightened determination from the Fed to fight inflation with tighter monetary policy.

As shown below, we expect that GDP growth will bounce back starting in 2024 as the Fed pivots to easing. The resolution of supply constraints should facilitate an acceleration in growth without inflation becoming a concern again. Increases to our GDP growth forecasts for 2025-26 partially make up for our downward revisions for 2022-23.

A bar chart showing Morningstar's current GDP forecast along with prior forecasts.

Though these GDP forecasts for 2022 and 2023 are slightly more bearish than current consensus, we’re far more bullish in the longer run.

Based on available long-run forecasts, we're expecting about 2.5% more cumulative GDP growth than consensus through 2026. Consensus remains overly pessimistic on recovery in the labor supply and has generally overreacted to near-term headwinds.

Our five-year GDP forecasts are driven by our detailed analysis of the labor market and the other supply-side building blocks of the economy.

Inflation Forecast 2022: Staying Hotter for Longer Than Expected

Our inflation forecasts for 2022 have edged higher, as recent data has shown inflation to be somewhat more entrenched than previously expected.

We’re still expecting inflation to come down dramatically in 2023 and later years as supply constraints are resolved, causing the price spikes for food, energy, and durables to unwind. Also, the slowdown in GDP growth—engineered by the Fed’s rate hikes—will weigh on economywide prices.

A bar chart showing Morningstar's current inflation forecast along with prior forecasts.

On inflation, our views diverge sharply from consensus after 2022. Bond market breakevens imply a similar view as consensus on inflation.

While consensus has greatly given up on the "transitory" story for inflation, we still think most of the sources of today's high inflation will abate (and even unwind in impact) over the next few years. This includes energy, autos, and other durables.

Combining these factors with monetary policy tightening, we expect inflation to undershoot 2% in 2024 and 2025. Worries about inflation broadening out into the rest of the economy (including via high wage growth) look overblown.

U.S. Interest-Rate Forecast: What We See for the Future

In the short run, our interest-rate forecast is centered on the Fed and its attempt to smooth out economic cycles. The Fed seeks to minimize the output gap (the deviation of GDP with its maximum sustainable level) while keeping inflation low and stable. When the economy is overheated (the output gap is positive and inflation is high), as today, then the Fed seeks to hike interest rates to slow down growth.

In the long run, the Fed largely disappears from the picture. Instead, interest rates are determined by underlying currents in the economy, like demographics, productivity growth, and economic inequality. These forces have acted to push down interest rates in the United States and other major economies for decades, by creating an excess of savings over investment. In other words, the natural rate of interest has shifted downward.

For this reason, our interest-rate forecast includes the expectation that these rates will stay lower for longer. Even if we’re wrong in our near-term view that the Fed’s war against inflation will be a short one, our long-term view on interest rates remains valid.

A version of this article was published on Sept. 21, 2022.